Insight - Monte dei Paschi harboured bank within a bank

SIENA, Italy (Reuters) - The secret document at the heart of the Monte dei Paschi banking scandal lay for months in a concealed safe in a 14th century Tuscan palace.

Chief Executive Fabrizio Viola said he learnt about the safe's contents only last October, a full 10 months after he had been called in to sort out Italy's third biggest bank.

The 2009 document revealing derivatives deals that have run up huge losses for Banca Monte dei Paschi came to light in the office of Viola's predecessor at the bank's headquarters in Siena.

"The document was in a safe, moreover in an office that was no longer mine," said Viola. "I don't think that the person who put it there had been trying to hide it. But there is no doubt that the document had not been used in the bank's accounting."

The document found at the 540-year-old bank's head offices - which are appropriately in a restored ancient fortress - was a contract mandating Japanese bank Nomura to carry out deals on behalf of Monte dei Paschi.

It revealed that, unbeknown to the new management under Viola, two derivatives transactions known as "Alexandria" which had looked separate were in fact linked. This meant they should have received different accounting treatment, leading to heavy losses.

This discovery prompted an internal inquiry that has, so far, revealed losses of up to 720 million euros ($977 million).

Monte dei Paschi is the only major Italian bank to have turned to the state for help, and revelations about the deals have also made its 3.9 billion-euro bailout an issue in campaigning for national elections next month.

The centre-right party of former prime minister Silvio Berlusconi has been critical although his government, which fell in late 2011, itself gave state support to the bank.

The Bank of Italy is also under fire, with critics accusing it of lax oversight and lack of transparency about suspected financial irregularities at the Tuscan lender.

The safe appeared to have been well hidden as there is no evidence that tax police found it when they combed the Siena offices in May, as part of an inquiry into Monte dei Paschi's 2007 acquisition of smaller lender Antonveneta.

The mandate document was found in an office on the fourth floor of the palazzo which had been used by former chief executive Antonio Vigni and is now occupied by board members.

"Vigni had left the document in the safe, but no-one knew about the existence of this safe," said a source with direct knowledge of the discovery.

Whether the contract was deliberately hidden or simply forgotten, Monte dei Paschi's former top management seems to have had little idea of what traders in the finance department that negotiated such risky deals were doing - despite repeated complaints from internal auditors, according to senior sources with knowledge of the situation and documents seen by Reuters.

Three years before the document was uncovered, Monte dei Paschi's own risk control unit and its audit committee had already expressed serious concerns to Vigni about the way the bank's finance department handled risky trades.

Internal documents obtained by Reuters show an audit of the department in August and September 2009 had uncovered a "systematic overshooting of risk limits" in the management of the group's 24-billion euro proprietary portfolio.

Proprietary trading involves a bank taking trading positions in securities such as stocks or bonds to make profits for itself, rather than trading on behalf of a customer.

Close examination of the documents, which included letters addressed to Vigni outlining the internal auditors' misgivings, suggest that the finance department operated like a bank within a bank, entering into derivative trades and hedging bets that went wrong with little scrutiny from Vigni or then Chairman Giuseppe Mussari.

Senior sources with direct knowledge of the situation have confirmed the picture they portray.

FREE HAND

Speaking on condition of anonymity, they said ex-finance department chief Gian Luca Baldassarri and his team were viewed as the real bosses inside the bank, with a weak understanding of markets among the top management allowing them to engage freely in opaque financial deals.

The finance department headed by Baldassarri was made up of about 60 people, including "back office" staff who handle paperwork connected to the deals.

But the people Baldassarri really trusted and worked in close contact with numbered no more than five. The finance department was based in Siena but had a trading desk in London, Europe's main financial centre.

"The risk management unit constantly raised alarm bells," said a senior source with direct knowledge of the situation. "However, these were very powerful people."

A former mid-level bank manager who had dealings with Baldassarri described him as "an affable finance wizard who did not use his status to put on airs and make people feel inferior".

Baldassarri - who worked at the bank between 2001 and 2012 - and another Monte dei Paschi manager in London are referred to as "the five percent gang", according to a judicial document seen by Reuters.

This document contains minutes of a 2008 interrogation conducted by a Milan magistrate of a former Dresdner Bank employee, Antonio Rizzo, as part of a separate Milan inquiry.

The "five percent" label refers to a fixed fee that, according to Rizzo, the duo would ask for themselves for every financial transaction they managed to push through.

The fees were paid to the two managers via a Swiss-based vehicle called Lutifin SA, the tax police - a specialist force that also handles financial investigations in Italy - said in its report, also seen by Reuters.

The former mid-level manager said Monte dei Paschi's top brass didn't grasp what the finance department was doing from its offices overlooking the Renaissance buildings of Siena. "They could do what they wanted because no one really understood what they were doing, neither Mussari nor Vigni," the official said.

Vigni declined to comment for this story while Baldassarri was not available to comment. Mussari, who had to step down as chairman of the Italian banking lobby last week, did not return calls. Monte dei Paschi declined to comment.

Nomura said last week that the derivative trade had been reviewed and approved at the highest level within Monte dei Paschi, including by Mussari. However, the Italian bank said later that its board had not reviewed the deal for approval.

PERFORMANCE ISSUES

Established in 1472 to lend to "the poor or miserable or needy", Monte dei Paschi was already being investigated by Siena prosecutors over possible bribes linked to its 9 billion-euro cash acquisition of Antonveneta, which stretched its finances to the limit just months before the global financial crisis.

Prosecutors are now also investigating "Alexandria", the complex 2009 structured transaction with Nomura, and two other deals - the 2008 "Santorini" trade with Deutsche Bank and the 2006 "Nota Italia" trade with JP Morgan.

Deutsche has said its deal had been approved by Monte dei Paschi. JP Morgan declined comment.

The documents obtained by Reuters do not refer specifically to the three derivative trades, which are alleged to have been used to conceal losses at Monte dei Paschi.

But the documents show Vigni, who received a four million euro severance payment when he left the bank, failed to implement adequate controls over Baldassarri's department and that warnings about dodgy deals were largely ignored.

Viola, who took over as chief executive of Monte dei Paschi in January 2012, fired Baldassarri shortly after he arrived.

Viola told reporters on Monday he took that decision not because he thought Baldassarri had done something illicit, but because of "performance issues" over the management of the bank's 37-billion euro financial portfolio.

Viola has laid off more than a hundred managers, some of them with close ties to the bank's previous leadership, and has taken action to improve corporate governance.

The bank, known as "Daddy Monte" because of its influence and patronage, has close ties to the Democratic Party (PD). The centre-left PD is leading in opinion polls before the February 24-25 elections, although Berlusconi's PDL has made up some ground since the scandal broke.

The town hall, the province of Siena and the Tuscany region, all run by the PD, name 14 out of the 16 board members at Monte dei Paschi's charitable foundation, which in turn picks half of the bank's board. The foundation is the top shareholder in the bank with a 34.9 percent stake while French insurer Axa and J.P. Morgan also have small holdings.

LITTLE VISIBILITY

In addition to the internal audit committee and the risk management department, some board members also criticised the type and size of investments carried out by the finance department and the lack of accountability, sources said.

In 2011, two board members - Francesco Gaetano Caltagirone and Axa representative Frederic Marie de Courtois d'Arcollieres - raised questions about what they said was an excessive exposure to Italian government bonds, according to a source close to the matter.

Caltagirone declined to comment as did Axa.

In a letter written in January 2010, Vigni called for increased accountability of the finance department and mentioned a planned revamp of the structure, already approved by the board. But in November 2010, after follow-up checks by the risk control unit, the audit committee was still not happy with the dealings of the finance department.

"It is necessary to intensify current efforts so as to complete the corrective actions started," the committee said in a document dated November 12, 2010, citing among others the need to strengthen controls on counterparty risks and collateral management.

Monte dei Paschi's 25-billion euro Italian government bond portfolio made a net return of just 65 million euros in the first nine months of 2012 because of a fall in benchmark European interest rates.

It would have made around 1 billion euros a year had the bank not carried out interest rate swaps in 2009 that moved almost the entire portfolio to floating rates, which fluctuate in line with the market, from fixed rates.

NO LIMITS ON VOLUME

The audit committee formally complained to Vigni that Baldassarri was using his own cell phone to execute financial transactions. This contravened the lender's rules, which demanded the use of the bank's fixed-line phones so that conversations could be recorded.

"Baldassarri replied that because he was making deals with Asia on a different time zone, he had to make the calls from home and could not use his office phone. In the end, nothing changed," a senior source said.

In a letter to the audit committee seen by Reuters, Vigni wrote that some trading operations had indeed been carried out by cell phone, and had therefore not been recorded, but were nonetheless properly registered with the front office.

A former executive at the bank said the board did not put any limits on the total size of deals Baldassarri could undertake. "There were some limits, not in terms of volume but in terms of risk. It was a strategic choice by the board," this person said.

"As in all banks there was a structure that could take risks and another one that was supposed to monitor that. As far as I know the Bank of Italy was aware of this model, and asked for changes. Probably this model was inadequate."

A November 9, 2010 Bank of Italy report, also seen by Reuters, showed how inspectors from the central bank had raised concerns about risky derivatives trades after they visited the bank from May to August 2010. The inspectors specifically raised the deals with Nomura and Deutsche, which are now at the heart of the scandal.

The Bank of Italy - led until 2011 by Mario Draghi who is now the European Central Bank Chief - has said it realised the "true nature" of the contracts late last year, after Monte dei Paschi's new management discovered the document in the safe. ($1 = 0.7370 euros)